Why Options Backdating is Wrong

Mark Stein has an excellent overview today of exactly what is wrong with options backdating (and I'm not just saying that 'cos he's my editor at Portfolio). Suddenly, after the vast amount of ink spilled on the topic, it all makes sense to me now.

There's a simple reason why this issue is hard to understand, and it's this: options backdating is not illegal. In fact, there's really no reason why options shouldn't be backdated. Historically, when executives have been given options grants, they've been given at-the-money options: the option to buy stock at the price the shares are trading at on the day the option is granted. That way, if the share price goes up, then the executive makes money; if the share price goes down, the executive makes nothing.

But there are other types of option, too: they can be out of the money, or they can be in the money. If an executive is granted out-of-the-money options, a tiny rise in the share price isn't enough for him to start making money. But a large rise in the share price can be very profitable. A grant of $1 million in out-of-the-money options is actually much more valuable if the share price goes up a lot than a grant of $1 million in at-the-money options would be.

Alternatively, executives can be granted in-the-money options. These options have value even if the share price goes down a little, although they lose their value if the share price goes down a lot.

The different types of options create different types of incentive for executives. An executive with out-of-the-money options has every incentive to take big risks, because only if the share price rises a lot does he get the big payout. An executive with in-the-money options, on the other hand, has an incentive to prevent the share price from falling. That's one reason to grant in-the-money options. Another reason to grant in-the-money options is to reward executives for increases in the share price which have already happened, under their watch, in the recent past.

Backdated options are a form of in-the-money option. And if there are good reasons to award in-the-money options, what's wrong with backdated options? Up until now, the best answer I've received to that question is that it's all about taxes. The tax implications of an options grant which is at-the-money or out-of-the-money are different from the tax implications of an options grant which is in-the-money. And if a company backdates an options grant instead of simply awarding an in-the-money option at today's share price, it's essentially trying to pull one over on the IRS, and get away with paying at-the-money taxes on an in-the-money options grant.

So is this just a question of tax accounting? It turns out that in fact it's bigger than that: the people currently being indicted are guilty not only of scamming the taxman, but also of fraudulently deceiving their own shareholders. Carole Argo of SafeNet, in fact, is accused of deceiving not only the company's shareholders but even its directors as well. When the options grants were announced, they were accompanied by a public statement that "no gain to the options is possible without stock price appreciation, which will benefit all shareholders." Which is fraudulently deceptive, if you ask me.

Similarly, shareholders of KLA-Tencor were never informed that options grants to CEO Kenneth Schroeder were in the money when they were made. Reports Stein:

Over all, KLA-Tencor, a semiconductor-equipment maker, used backdating to hide more than $200 million in stock-option compensation. The S.E.C. said it did so to avoid reporting the expenses to investors...
"Corporate executives who deliberately backdate options grants and skew their books to hide compensation expenses are misleading shareholders and investors about the earnings of the company and painting a false picture of executive pay," U.S. Attorney Michael J. Garcia said in a statement.

That's what's wrong with backdating. Companies can incentivize their executives any way they like. But they can't lie about it to shareholders.